Kevin Telfer, fixed income product specialist at Kames Capital, looks to the reasons why investors would continue buying bonds even as real yields in many cases are marginal or even negative.

Most of us would agree that AAA government bonds are expensive. With yields on US, German and UK 10 year government bonds comfortably below 2%, compared to historic measures and current levels of inflation, there would appear to be little merit in investing in them. But as is often the case, the reality is more complex.

Firstly, there are “forced buyers” who are compelled to buy government bonds irrespective of their yields and indeed may need to buy more the further yields fall. Secondly, central banks are price insensitive participants in bonds markets. Finally, there are active investors looking to add value from yields continuing to fall.

We are often asked who these forced buyers are and who or what is forcing them to buy government bonds. Put simply, large institutional investors are subject to regulatory requirements which effectively require them to hold government and high quality corporate bonds.

Pension schemes and insurance companies have obligations to provide benefits to their members/customers and are regulated with the objective of ensuring these obligations are met. The details vary from country to country and there are differences between how insurance companies and pension schemes are regulated. But the overarching theme is that they are required to place a value on their future obligations and hold sufficient assets to cover these obligations. The future obligations are valued conservatively to reduce the risk that not enough assets are held, with reference to the yields of high quality, “safe” bonds.

There is no actual obligation to only invest in such bonds but most usually feel compelled to make at least a significant allocation to bonds as investing elsewhere creates the risk that their “funding position” ie, their ability to cover the value of their obligations is compromised. This is because when the reference bonds’ yields fall and they rise in value, the value placed on the obligations also rises in value. If the achieved investment returns do not keep pace with the increase in the value of their obligations, the funding position weakens requiring remedial action eg, pension schemes may seek an increase in contributions from their sponsors.

In addition, insurers that choose not to fully invest in the reference bonds usually have a regulatory requirement to hold additional assets in recognition that their riskier investment strategy may go wrong. This is obviously a constraint on their activities, although over time they would expect to benefit from the alternative investment strategy.